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Is It Time to Cash Out?

With all of the concern over the credit crisis, the bailout package, and the troubles facing Corporate America in general, let's not forget what the average working American is now facing:

A recession that may last through 2009.

Rising inflation.

A stock portfolio piling up huge losses.

Stagnant or declining home values.

The cancellation of that Christian Slater show.

I hate to be a downerThat's a not-exactly-rosy picture. Belts are tightening in households across the country, and for good reason: This is a downturn without much precedent. I don't believe there's a question of whether we'll bounce back from this, but there's no clear answer on when that'll be.

But there's one thing you should absolutely avoid, if at all possible. It's a decision that will save you tens of thousands of dollars and allow you to retire earlier. Please, if you are debt-free, and have emergency money set aside, please don't cash out your 401(k).

Seem obvious? Think again. A 2005 survey from Hewitt Associates showed that almosthalf of employees took a cash distribution of their 401(k) plan when leaving a company. Not because they needed the cash for a new roof or medical care, but simply because they were switching jobs! And these aren't recent college grads with less than one month's rent in the account -- 42% of those who cashed out were aged 40-49!

The not-so-golden yearsAccording to the U.S. Department of Labor, the average American will have 10 jobs between ages 18 and 38. When leaving one job for another, you have the choice to cash out your 401(k), keep your account with the old employer, or roll it over to the new employer or into an IRA.

Unfortunately, too many folks are shooting their retirement in the foot. Taking what may look like the road with less paperwork will end up costing you big time in the end. In fact, Motley Fool Rule Your Retirement advisor Robert Brokamp has said that cashing out your 401(k) is among the worst possible financial moves you can make, for many reasons:

Investors face an automatic 10% early withdrawal penalty if they are younger than 59 1/2.

Because of IRS rules, employers have to hold back 20% of your account balance for taxes.

Retirement accounts are protected in the event that your company (or you) declared bankruptcy.

Most importantly, even if your account balance is relatively small, you're cheating yourself from years of compounding interest. According to the U.S. Department of Labor, workers will have to save threetimes as much per month for every 10 years they delay.

Ouch.

This is an especially bad move nowCashing out is extremely tempting -- especially if you've seen the value of your portfolio decline in recent months. But point No. 4 above is a major reason why you should be looking to add to your 401(k)s right now.

That's right, adding to. I know things have been brutal for the past year, but it's a fantastic time to be a net buyer of stocks or funds right now. Warren Buffett has said as much (in a New York Times op-ed), and his holding company has been putting cash to use by taking stakes in Constellation Energy (NYSE: CEG) , Goldman Sachs (NYSE: GS) , and General Electric (NYSE: GE) .

This is a buyer's market. Many institutional investors have to sell, and in the process, they're some great businesses down to prices that may well fall below their intrinsic value. The beauty of the 401(k) is that it allows you to dollar-cost average into a great funds such as, say, Bridgeway Large Cap Growth (BRLGX). This fund has had a tough year, but manager John Montgomery is one of the best in the business. His fund currently owns a few solid businesses that've been hit hard: Apple (Nasdaq: AAPL) , Microsoft (Nasdaq: MSFT) , and Amazon.com (Nasdaq: AMZN) . Coca-Cola (NYSE: KO) , down only about 25% year to date, is also a top 25 holding.

These are sound business built for the long run. By sticking them in your retirement plan -- and by allowing dollar-cost averaging to limit your itch to try to time the market -- you'll be getting a heck of a lot more shares of these great businesses, which you can allow to compound for years.

On the road to retirementOf course, my long-term bullishness in no way disregards the seriousness of the current economic climate. But unless you're in debt or have cash emergencies right now, cashing out your 401(k) will probably be a terrible impediment to a happy retirement.

Never forget the rules of investing, as set forth by Foolish retirement expert Robert Brokamp:

If you need the money in the next year, it should be in cash.

If you need the money in the next one to five (or even seven) years, choose safe, income-producing investments such as Treasuries, CDs, or bonds.

Any money you don't need for more than seven years is a candidate for the stock market.

Live by these rules, and you'll thank yourself down the road.

Advice from the prosNeed help making educated decisions about your retirement -- and staying disciplined throughout market turmoil? Robert and the Rule Your Retirement service may be able to help. For model portfolios, expense planning, and estate and tax tips, check it out free of charge for 30 days. We offer a free trial with no obligation to subscribe. Just click here for more details.

Claire Stephanicowns shares of Apple. The Fool owns shares of Bridgeway Large Cap Growth. Apple and Amazon are Stock Advisor recommendations. Microsoft and Coke are Inside Value recommendations. Bridgeway Large Cap Growth is a Champion Funds recommendation. The Fool has a disclosure policy.

Comments from our Foolish Readers

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I am certainly in agreement on this, but I know I can only speak for myself.

The reason I signed up with the Motley Fool was because I watched an old video of the two of them that was made for public television several years ago; it was at the same time that I realized I had to get serious about investing. So I am new here, and new to investing on a site where most people (I would assume) have been doing this for years and know a great deal about it.

I increased the contributions from my 401K to the maximum of 9% two years ago; it is matched at the same level, and I am determined to find out everything I can about the funds I have. I am not a young man, but I have about 18 years until retirement, so at least there is a small window of time.

I'm not sure how many Americans are completely debt free. Maybe many here are. My debt is manageable, but there are more and more people who either have to raid their retirememt fund - or not eat.

I did essentially what the article warns against (cashing out an IRA = 401K) in early 2004, not because I needed the cash, but because I don't trust the government. Most of that money had been in gold stocks, and nearly all of it went into gold coins at around $425/oz. To date, this has proven a very wise investment move. In my case, I do it as a hedge against the ills of the stock and bond market, where most of "my" retirement money is invested, and in my case, over which I have no control.

My SEP IRA is almost all short the market via the SDS ETF and is up over 50% in the past year. I expect much more on the downside but for those who aren't as brave I suggest you continue to add to your retirement fund, especially when the market is heading lower.

Here is a strategy that can't miss in a voilatile market but will limit your returns in a nice, slow moving bull market: invest half your stock portfolio in a short ETF such as SDS and invest the other half in a long ETF such as SPY. Do the math; you will make money if the market goes up OR down and if you continually readjust the 50/50 balance when it goes out of balance by 10-20%, you can do quite well as the market jumps up and down.

Do the math: if the market goes up 20% you will gain 20% on the long side and lose 10% on the short side. If it goes down 20% you will gain 40% on the short position and lose 20% long.

Now you're thinking that it can't wok or everyone would use it and you would be correct in that in a normal, non-violatile martket it would only limit your returns but in a voilatile market it keeps you safe and profitable.

It is not a pretty sight to watch your retirement savings dwindle down to almost nothing. But, I think the best thing to do is to learn from this opportunity. Could we have chosen investments that could have "weathered the storm" better, could we have been more proactive in reviewing our portfolios on a more consistent basis and possbily making re-allocations based on the present economy and the direction it was heading? Maybe, everything will workout ok in the long run and the businesses we have invested in will do just fine.

Through all of this, what may seem chaos and confusion, let us emerge more disciplined and intellegent investors.

Hind sight is always better in this business. You need to do your homework and be blessed to do well. Don't be rash or impulsive. Think before you act and consider gradual movement rather that the extremes like totally pulling out. Perhaps move a portion to a cash like or bond environment.

Any comment based on what someone could have done and how that would have worked out is worse than worthless. "If I'd cashed out everything in August of 2007 I'd be a lot better off today" -- well, yeah. A lot of things would be different if we knew how things were going to work out. Why stop there? How about if you'd bought Microsoft in 1986 and sold it in 2000? How about if you hadn't lost your keys that one time?

Second guessing is always easy. So are brave predictions of doom that is "eventually" going to happen. Well, in the long run we're all dead, but the fact that some day the sun will flame out and extinguish all life on earth is not useful information for making realistic choices today.

Well I've been going through the application with Braemar (http://pension-release.com) to free up some of my pension savings, and to be honest, I'd quite like to release the whole lot!

It's not easy to look back in hindsight and say "oh, I should have put my faith here". And in my position, it'd drive me insane if I did. Nobody likes the downward spiral that we've fallen in to, but we can only learn from it.

1. Motley you are absolutely correct about the detriments cashing out a 401k, however rolling over a 401k to an IRA or another 401k has no penalty or tax implications. In your statistics, how many of those 401k cash withdrawals were then rolled over to another 401k or IRA within the 60 day grace period?

2. Fred Voetsch – Leveraged investments are way beyond the average person and most professional’s knowledge and risk capacity. My understanding is, if the market goes up 20% as in your example the leveraged short position would lose twice that amount.

If you own SDS as of yesterday, you would receive a cash distribution in your account of approximately 11.49 per share.

…Also, you miss out on further appreciation of this amount because your amount invested actually dropped.

Therefore, to stay invested, you have to multiply $11.49 by the number of shares you own, then divide by the current price. This tells you how many shares to buy back today. In effect, spending the dividend money to recover the shares.

This is known as re-investing the dividend.

Let's go over an example. You had $100,000 worth of SDS yesterday. SDS closed at 87.44 yesterday. So you had 1144 shares.

Today, it opened at 75.40. You know you will receive $11.49 per share distribution.

11.49 x 1144 / 75.40 = 174

You have to buy 174 shares of SDS at the open today to bring your account back to the same potential of SDS you had before.

POSTED BY LAWRENCE CHIU AT 1:22 PM

And finally from Investopedia:

Short selling involves many unique risks and pitfalls to be wary of. The mechanics of a short sale are relatively complicated compared to a normal transaction. As always, the investor faces high risks for potentially high returns. It's essential that you understand how the whole process works before you get involved.

Brad, The above applies whether investing directly or through a manager.

Go to www.ifa.com to see market risk expected returns without the added risk of a broker, active manager, guessing, timing or leveraging. Education is the best defense against bad investment decisions and helps you to understand your true risk capacity. This is Brad von Grote's view not necessarily the view of IFA of which I am employed as an advisor.

It is time to cash out our 401k. This is the top. And you may never see DOW 9000 for the rest of your life.

In a deflationary crash, even though FED makes credit easier, it is hard to turn the boat around due to the following reasons:

1. Lenders (banks) do not want to lend because they think they may not get their money back. This is because the money supply is shrinking rapidly. All prices around you were based on inflated bank credit. People borrowed and bought things and inflated prices along with salaries. It is very possible that all prices and salaries can be cut in half if the money supply shrinks 50%. Then it will be very hard to pay back a fixed rate loan.

2. Borrowers do not want to borrow because they think they may not be able to pay it back. This is normal because people see job cuts, companies cut costs, prices fall, so how can they be sure that they will make same salary in the future to pay back what they owe.

3. For inflation to happen, people must have alot of money to chase too few products. What we have now is the opposite. We have wage reduction. We have high debt levels. We have excess capacity producing too many products. The supply exceeds the demand. The prices will fall, not go up. All companies are selling less, good results are just a result of cost cutting. When one company does it, it is good. But when all companies do it, cost cutting is detrimental to the economy. Earnings will go lower. Imagine an IT company produces software and hardware, but cuts costs: layoff workers, freeze salaries, stop investments. Their customer is a bank. If the bank cuts costs what will they do? They will say: Hey we are not buying new software from this IT company this year. We will run with fixer upper systems we have, sorry. This mentality will effect everyone's earnings! It may sound good for the bank, but it is bad for the IT guy. There is a chain reaction.

Almost all of the money supply in the economy is in terms of bank credit. This monetary system is prone to a deflationary crash. There is a herd effect in the population. People borrow and spend alltogether and they stop borrowing alltogether. This creates cycles like kontradiev wave. The herd effect causes great booms and great busts. This is explained in Conquer the Crash:

Maybe for people who have a lot of money to buy big-ticket discretionary items. For people who spend almost all their money on the essentials -- food, utilities, health care, insurance and taxes -- "deflation" is a hoax. And to make it worse, many of them have income that is tied to the CPI which is lower because of the discretionary items they don't buy. Double whammy.

ziggy29, deflation is not just falling prices. deflation is reduction in money supply. deflations effect is visible in home values, stock values, commodities, gold, silver, every where you look. Money supply is deflating. That is our problem. Since there is less and less money to earn, people loose their jobs, companies go bust, banks would not exist now if FED did not print money to cancel out their losses. Here is how bank credit has been inflated and why it will deflate:

These guys, http://www.pensionreleaseuk.com, said that I could release 50% of the cash in my pension as long as I'm not a connected party. What does that mean and how do I know if I am a connected party?

401(K) services are typically expensive. Roll over to an IRA. Invest in ETF's. Why pay a money manager for doing something most money managers can't do- beat the averages. You will SAVE THOUSANDS in the long run.

Index funds? Only if they cost no more than an ETF. Plus ETF's have more flexibility.

Investing? Be wise. Do not try and OUTSMART Wall Street. You must use all the tools available to you and wait for opportunities.

Most every advisor focuses on "profits" or "best stocks" or "buy and hold". All these themes enrich those that are SELLING the services and products.

Investors are brainwashed by all the industry marketing and do not UNDERSTAND how the system really works.

The THEME the small investor should focus on is protection of assets. Buy opportunity- just do not invest. MOST OF THE TIME, MOST INVESTMENTS are too expensive.

Investing aside for a moment, what does your 401(k) offer? Is it expensive? What are the fee's? Does your employer MATCH any of your contributions?

If it is a good deal from a cost perspective, you can always keep the money in the 401(k) in a money market fund until you are ready to "invest" it.

Remember, all 401(K) plans are different. They are products with costs! Combine that with poor investment guidance and you have disaster- like being down 30-40%.. . And you paid high fee's for the privilege.